from the advanced-economic-concepts dept

Jameson Ahern points us to a fantastic discussion by Josh Lehman, explaining why it's silly to argue that people are irrational for spending $4 or more on a cup of coffee*, but not $0.99 on digital content or apps. As with nearly all cases of seemingly "irrational" behavior in economics, the truth is that you just need to better understand the marginal benefit that people are getting and the true marginal costs, which often go way beyond the dollar amount. Lehman points out a few key examples, with the focus on trust & certainty, as well as the difference in the competitive market.

For the first point, he notes that you know exactly what you're getting with a Starbucks cup of coffee and how much you'll enjoy it:

I know I’ll like my cup of coffee. It will fully meet my expectations. For the $4 I spend I don’t expect it to change my life. I don’t expect it to even last beyond its last drop (and a trip to the bathroom later). It’s an experience I can fully trust will be pretty much the same each time. There’s no gamble here. Ask me if I’d like to drop $4 on a cup of your new “Instant Refresher Juice 1.0″ and there’s a very good chance I’ll pass. Or, maybe I’ll ask for a free sample to see if your $4 Instant Refresher Juice 1.0 is as good as Starbucks Coffee. In short, I know what I’m getting for $4 and I’m getting that same experience every time I hit the drive thru.

What he's really pointing out here is that there's a much bigger cost to your content than just the $0.99 it's being offered for. It's the risk of not getting any actual value out of it. And since people are, quite naturally, loss averse, they're much more hesitant to spend under such circumstances. This is completely rational behavior.

He also points out the general nature of the market, and whether or not there are reasonable "free" alternatives:

When you walk up to the counter of your local coffee shop you are not asked, “would you like a cup of our free coffee, or would you like to select from our paid options?”. If Starbucks gave out free coffee every day there would be mile-long lines at the drive thru. If the free coffee was anywhere close to as good as their paid stuff people would abandon the paid en masse. Some would pay maybe because they felt bad, as a freeloader. Others would pay because they preferred the options available to them in the paid column vs. the free. Now imagine the free selection at starbucks was nearly as large, or larger, than the paid selection: Welcome to the App Store.

In other words, as we've explained for years, the nature of the wider market really matters. In competitive markets, price gets driven down towards marginal cost. There are ways to prevent that -- and one is to build up brand value through things like trust and certainty (see the point above). So while there are cheaper alternatives, or even in many cases "free" alternatives at people's workplaces (contrary to Lehman's suggestion that there are no such alternatives), people still flock to the one they know and trust. But if there are lots and lots and lots of free alternatives, then you have to work much harder to justify the price. In some cases, for some people, you can. But the market situation between coffee and apps is not very close at all.

Lehman makes some other points as well, but the key one is that these are totally different markets with different factors playing on pricing. Comparing them in absolute dollar terms misses the full costs and full benefits associated with the purchase.

* Moreover, despite the "$4 coffee" being an oft-repeated trope about Starbucks, it's not really true. The biggest cup of coffee at Starbucks costs a little over $2. The drinks that are pricier than that are generally about nine-tenths milk, and milk is much more expensive than coffee. Indeed, the drinks that so many people think are a "ripoff" are not where Starbucks makes the majority of its money—they tend to be much lower-margin items than the plain coffee, because milk and whipped cream and fancy syrups are all high-cost and expensive to store. Is Starbucks still "expensive"? Maybe so -- but anyone who opens that discussion by talking about the "$4 cup of coffee" demonstrates a fundamental misunderstanding of how the business functions (and even of what's on the menu).